It’s Not Too Late to Buy Red-Hot Industrials

by Daniel Putnam | November 18, 2013 11:16 am

Industrial stocks typically aren’t seen as being exciting investments, but the “big uglies” have been rewarding investors with blistering returns in 2013. The Industrials SPDR (XLI[1]) has checked in with a year-to-date gain of 34%, outpacing the 28% gain of the SPDR S&P 500 ETF (SPY[2]) by a comfortable margin.

The rally has been broad-based, with nine of the sector’s 10 largest components beating the S&P thus far in 2013. Even General Electric (GE[3]) — hardly thought of as a source of beta! — has outpaced the index with a gain of nearly 33%.

The primary catalysts for industrials’ market-beating returns has been the improving outlook for global growth and the absence of the persistent negative headlines that characterized the previous two years.

With the U.S. economy improving, Europe on track to move out of a recession in 2014 and talk of a “hard landing” in China fading into the background, investors have been feeling better about rotating out of defensives and into economically sensitive sectors.

In this sense, industrials are making up for lost ground after underperforming the broader market in both 2012 and 2011.

Love Across the Board for Industrials

And the gains have been widespread. While Caterpillar (CAT[4]) and JohnDeere (DE[5]) have disappointed, their shortfall has been more than made up for by the strength in other areas.

Most notably, the aerospace/defense group has been a source of outstanding returns. Boeing (BA[6]), United Technologies (UTX[7]) and Precision Castparts (PCP[8]) have been boosted by rising demand for commercial airliners in the emerging markets, while the major defense contractors have rebounded from last year’s fears that the budget debate would lead to lower defense spending.

The table below shows the outstanding performance for the larger names in the defense group, and this doesn’t even account for the strength in smaller stocks such as Heico (HEI[9]), ahead 49% year-to-date, and Elbit Systems (ESLT[10]), up 35%.

Stock

Ticker

YTD Return

Northrop Grumman

NOC

65.8%

Lockheed Martin

LMT

53.4%

Raytheon

RTN

51.2%

Honeywell International

HON

41.2%

General Dynamics

GD

31.0%

The transports also have delivered spectacular returns amid declining fuel costs and the improving growth outlook. The gains have been broad-based here as well, with strength in delivery/logistics — FedEx (FDX[11]) and UPS (UPS[12]) are up 52% and 41%, respectively — airlines, and rails. The biggest winner here: Delta Air Lines (DAL[13]), up 138%.

The key question now is how long industrial stocks can continue to ride the current wave of optimism.

Valuations are a lot richer now than they were at the beginning of the year, and dividend yields have become less attractive. A number of individual stocks are trading at the high end of their historical valuation ranges right now, as well: Boeing, for instance, is trading at 24 times trailing earnings and 18 times 2014 estimates. Industrials as a whole are trading at a premium price-to-earnings ratio to the S&P 500 Index (15.7x vs. 14.7x), yet 2014 earnings estimates are lower (10.1% vs. 10.8%). Revenue growth for industrials also is expected to come in below the broader market next year, at 3.9% vs. 4.6%.

This indicates that for the gains to continue in the coming year, 2014 estimates need to hold steady or improve from current levels. And so far, that’s the case: In the past 90 days, all of the sector’s major constituents — with the exception of Caterpillar — have seen next year’s earnings estimates remain relatively stable.

By the same token, however, the sector is priced for a very positive scenario in 2014 — in this case, a robust recovery in the global economy. If that indeed proves to be the case and growth satisfies or exceeds expectations, industrials can continue to outperform.

On the other side of the equation, slower-than-expected growth would suddenly leave the sector out over its skis in terms of its valuations. As a result, the sector as a whole has become very headline-sensitive at this stage.

Bottom Line

Ride this wave as long as it lasts, particularly if the global-growth story comes through as expected. Industrials outperformed for two years in a row in 2003-04, and that could certainly happen again.

But with valuations elevated and strong returns already in the books, be ready to take profits at the first sign of trouble.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.